Basis fund misses margin calls, research firm says Well-regarded Australian firm latest to be hit by subprime mortgage turmoil By Alistair Barr, MarketWatch Last Update: 3:10 PM ET Jul 19, 2007 SAN FRANCISCO (MarketWatch) -- Basis Capital, a firm with more than $2 billion in assets that was named Australian hedge fund of the year in 2006, has become the latest to be hit by turmoil in the subprime mortgage market. The Basis Yield Alpha Fund (Master) has failed to meet margin calls and some of its lenders have declared the fund in default and are trying to seize its assets, Zenith Investment Partners, a research firm, wrote in a report on Thursday. Zenith's report cited a notice that Basis Capital sent to investors on Wednesday. Basis warned that if its lenders seize assets of the Basis Yield fund and sell at "distressed sale prices," the net asset value of the fund could be halved compared to its May 31 level, Zenith's report said. Basis Capital, founded in 1999 by Steven Howell and Stuart Fowler, didn't return a phone call and an e-mail seeking comment on Thursday morning. Zenith also didn't return a call and an e-mail. Merrill Lynch is the fund's prime broker, according to Basis Capital's Web site. A spokeswoman for the investment bank declined to comment. J.P. Morgan Chase, Morgan Stanley are creditors to the fund, the Financial Times reported on Thursday. The Basis Yield Alpha fund lost roughly 14% in June, according to a letter the firm sent to investors earlier this month. MarketWatch obtained a copy of the letter. Another fund, the Basis Pac-Rim Fund, was down more than 9% in June, the letter also disclosed. Basis said in the letter that losses were partly caused by turmoil in the subprime mortgage market. The firm noted that rating agencies Standard & Poor's and Moody's Investors Service downgraded several subprime mortgage-backed securities this month, with S&P focusing on lower-rated subprime home loans originated in 2006, a year of aggressive underwriting and housing market speculation in the U.S. Despite deliberately avoiding securities linked to 2006 subprime mortgages, Basis said that its funds' "otherwise fundamentally sound collateral" had been hit by brokers marking the value of the assets to market "indiscriminately." "This indiscriminate pricing is largely the result of a market-wide lack of liquidity, which has resulted in very little collateral actually being traded," Basis explained in the letter. Negotiating with creditors After missing margin calls, the Basis Yield fund is negotiating with creditors and has appointed accounting firm Grant Thornton to help with an orderly sale of assets at prices which reduce the losses to investors, Zenith's Thursday report said, citing Basis's July 18 notice to investors. "This latest information is obviously very concerning as the effect of the default with its financiers' results in Basis losing control of the timing and potential sale price of securities in the portfolio," Zenith said in its research report. "There is no way to determine the likely action of the financiers and the prices they may achieve for the sale of securities in the portfolio. This could lead to significant losses to investors in the Yield Fund," the firm added. Basis suspended investor redemptions from the Yield Alpha fund and another called the Aust-Rim fund earlier in July, Zenith also said, noting that "it will be a number of months, at best, before investors are able to access their investment." The Aust-Rim fund hasn't defaulted on any margin calls at this stage and none of its borrowing arrangements have been cut, Zenith reported. However, the fund has some of its money invested in the Yield Alpha fund, so it is affected by the same issues, the firm added. Awards, top-ratings Basis Capital was a well-regarded hedge fund firm that won several awards and garnered top ratings from Standard & Poor's and others in recent years. It won Hedge Fund of the Year at the 2006 Australian Hedge Fund Awards in Sydney. Industry publication AsiaHedge named the firm the best hedge fund in the fixed-income, high yield and distressed category in October. A year earlier, Basis won AsiaHedge's Fund of the Year award. Assirt, a fund research firm owned by S&P, gave the Basis Yield fund a "very strong," five-star rating. Other research firms were also full of praise. InvestorWeb gave the fund a four-star "buy" rating and Lonsec and Zenith said it was "highly recommended," according to Basis' Web site. S&P put its ratings on two Basis hedge funds "on hold" on Thursday. "S&P has been unable to secure a meeting with the management of Basis Capital, and to date our phone conversations with the manager have not provided the level of insight we require, S&P fund analyst David Erdonmez, said in a statement. April confidence The Yield Alpha fund was up more than 14% during the 12 months ending April 30, according to an investor update on Basis Capital's Web site. Basis said it had recently bought "heavily discounted" collateralized debt obligations (CDOs), including A-rated CDO securities that were trading at more than 700 basis points above the benchmark London Interbank Offered Rate (Libor). Those securities were trading roughly 100 basis points above Libor a year earlier, the update said. CDOs are a bit like mutual funds. The vehicles bought a lot of the riskier parts of subprime mortgage-backed securities that other investors didn't want in recent years, helping to fuel the U.S. housing market boom. But CDO and subprime mortgage-backed securities markets have been roiled this year as delinquencies jumped and rating agencies like S&P and Moody's downgraded some securities. Basis said in its April update that the CDO market was abuzz with reports that traders who were betting against the asset-backed securities (ABS) market were having trouble getting out of their positions profitably. "The ABS market has traded up since early March and it will be interesting to see liquidity and sensible valuations return," Basis concluded its April update. However, some parts of the ABS market have deteriorated sharply since then, judging by the ABX indexes, which track subprime mortgage-backed securities. An ABX index linked to BBB- rated tranches of mortgage-backed securities issued during the first-half of 2007 dropped to 45 this week. It traded above 65 in April and May. Alistair Barr is a reporter for MarketWatch in San Francisco.